California Franchise Tax Board to Enforce Withholding on Non-Resident S Corporation Shareholders

January 12, 2007
By Phil Jelsma and Mark L. Mann

The Franchise Tax Board has announced that it will, as of January 1, 2007, enforce a 7% withholding tax on distributions of California source income to non-California S corporation shareholders. Although the Franchise Tax Board has required withholding on distributions to non-resident partners and members of LLCs, historically, it has not enforced the same requirement on S corporation shareholders. Nevertheless, to help address the state’s projected deficit in 2007, the Franchise Tax Board will begin to require California S corporations and foreign S corporations qualified to do business in California to withhold 7% of distributions of California source income to non-California shareholders. The Franchise Tax Board does not require withholding if one of the following exceptions are met:

  1. The S corporation shareholder is a California resident;
  2. The S corporation shareholder is a parent corporation qualified to do business in California or has a permanent place of business in California;
  3. The total distributions are less than or equal to $1,500 during a calendar year;
  4. The S corporation has received a withholding waiver from the Franchise Tax Board;
  5. The distribution is tax-exempt income; or
  6. The S corporation shareholder certifies that the income was previously reported on the S corporation’s shareholder’s California tax return.

The Franchise Tax Board will require withholding even if the S corporation has previously reported losses to the same shareholder, however, waivers may be obtained in the following circumstances:

  1. The S corporation shareholder consistently files a California return and makes estimated tax payments when required.
  2. The S corporation shareholder is included in a group or composite return. Individual nonresidents may elect under Revenue and Taxation Code Section 18535 to file a group return in lieu of filing individual returns.
  3. The S corporation shareholder can demonstrate that the 7% result in overwithholding. Waiver is obtained by filing a Form 588, Nonresident Withholding Waiver Request. Withholding must generally be paid within 20 days of the month following the date of distribution. A Form 592, Nonresident Withholding Annual Return, and Form 592-B, Nonresident Withholding Tax Statement, are due to the Franchise Tax Board by January 31 of the following year for the S corporation shareholder.